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Rumblings on Risk

Forget beta. Find stocks that are already down and have the fundamental risk wrung out of them.

Sure, snake oil salesmen sometimes make people feel better, but more often than not they just prevents folks from getting useful treatment. The same holds for finance pros. Many say they can measure investment risk as if it were a science, and that risk measurement, equated with price volatility, can be used to spot hidden gems. Don't believe it, Fools. There are better ways to size up risk.

Analysts love to blather on about beta. On its own, beta is a fairly simple idea. It's also pretty useless. A stock's beta is a number representing its volatility relative to the overall market. The higher a stock's past volatility in relation to the market, the higher its beta. If a stock perfectly matches the market, its beta is 1.0. High-beta stocks are supposed to be riskier than low-beta stocks.

If you took beta seriously, you would have to say that General Electric(NYSE:GE) at $34 is less risky with a beta of 0.85 than it was a year earlier at $21 with a beta of 1.3. But it was GE's free fall that gave it the higher beta and reduced its risk -- and made it cheap. Buying after a big drop means a higher beta, but if all else is equal the stock has to be less risky than before the drop. A great investment will have a high beta, too, only because it's been moving around more than the market over a prolonged period of time.

Fundamentally speakingLet's be frank, no magic formula exists to reveal real risk. Beta tells you how much a stock bobs around, but it scarcely gets at more fundamental risk matters. Is there a risk that the company's industry will suffer a slump or, even worse, it won't be around in five years? Is the company vulnerable to competition stealing away its market share? Is there a risk that top executives are cooking the books? Even worse, is there a risk that you are caught up by momentum and are paying 10 times what the stock is worth? Fussy measures like beta don't come close to capturing risks like these.

So, what should investors do to size up risk and spot a hidden gem?

For starters, have at look the company's fundamentals. Risk assessment begins with a look at financial strength. Financial strength starts on the balance sheet. Pay attention to debt-to-equity ratios and cash positions. Which software company has more strength, Microsoft(NASDAQ:MSFT) with $53 billion in cash, or Oracle(NYSE:ORCL) with $8 billion? In the airline industry, compare the risk attached to money-making Southwest Airlines(NYSE:LUV) with loss-making, debt-laden incumbents Continental Airlines(NYSE:CAL) and American Airlines(NYSE:AMR).

Make sure accounts receivable (money owed the company) and inventory aren't growing faster than sales, as it suggests things are getting out of control. Think Dell(NASDAQ:DELL) with its tight control of production flow versus riskier Hewlett-Packard(NYSE:HPQ)

Consistency and reliability of earnings also signal investment risk. Starbucks(NASDAQ:SBUX), for instance, has gained the trust of investors over time with its quality and transparent earnings statements. By contrast, there's Kodak(NYSE:EK), which recently posted a pro forma profit of $0.70 a share in the fourth quarter. But add back special costs, however, and the firm's earnings drop to just $0.07.

It doesn't stop there. How safe are earnings and cash flow into the future? Does the company have the ability to sail through hard times? That means factoring in fundamentals like industry outlook, business cycles, competitive position, and management capability.

And yes, price does matter, when looked at against those fundamentals. Indeed, Warren Buffett, chairman of Berkshire Hathaway(NYSE:BRK.A), states simply that risk largely depends on the price you pay. Let's say you were to buy shares of ExxonMobil(NYSE:XOM) for today's $43 share price. All other things being equal, that is riskier than buying ExxonMobil back in December at $34. As Buffett says, "The greater the potential for reward, the less risk there is." In other words, the lower the price you pay, the greater your margin of safety.

Roll up your sleevesIt's clear that a good bargain carries less risk and higher reward potential. When you buy a stock, you are buying a part of a business. To know whether or not you are getting a good deal, you must evaluate the business. Valuing companies can be tricky sometimes, but it's not impossible. Yes, it probably means a lot more work than just looking up betas. But it's this kind of fundamental research that allows investors to curb their risk.

Forget the snake oil. If a stock has solid business fundamentals and is available at a significant discount to its value, the risk is lower and the prospect of reward is higher. Face it, unearthing hidden gems doesn't mean balancing risk and reward. It's about finding high returns and low risk in the same stock.

Tom Gardner searches for undervalued stocks each month in Hidden Gems. Sign up now for a free trial.